The State s Economic Outlook

Transcription

1 An Economic Report to the Governor of the State of Tennessee The State s Economic Outlook January2009

2 An Economic Report to the Governor of the State of Tennessee Matthew N. Murray, Associate Director and Project Director Center for Business and Economic Research Prepared by the Center for Business and Economic Research College of Business Administration The University of Tennessee Knoxville, Tennessee In cooperation with the Appalachian Regional Commission Tennessee Department of Finance and Administration Tennessee Department of Economic and Community Development Tennessee Department of Revenue and Tennessee Department of Labor and Workforce Development Nashville, Tennessee The State s Economic Outlook January2009

3 Acknowledgements Contributors to this Report An Economic Report to the Governor of the State of Tennessee Authors Center for Business and Economic Research Matthew N. Murray, Associate Director and Project Director William F. Fox, Director Vickie C. Cunningham, Research Associate Erin J. Middleton, Research Assistant Professor Kara D. S. Mitchell, Graduate Research Assistant Zachary W. Richards, Graduate Research Assistant Bryan Shone, Graduate Research Assistant Agricultural Policy Analysis Center, Department of Agricultural Economics Harwood D. Schaffer, Research Associate Kelly J. Tiller, Assistant Professor Daryll E. Ray, Blasingame Chair of Excellence Professor Project Support Staff Betty A. Drinnen, Program Resource Specialist Carrie B. McCamey, Communications Coordinator Laura Ogle-Graham, Business Manager Melissa O. Reynolds, Research Associate The preparation of this report was financed in part by the following agencies: the Tennessee Department of Finance and Administration, the Tennessee Department of Economic and Community Development, the Tennessee Department of Revenue, the Tennessee Department of Labor and Workforce Development, and the Appalachian Regional Commission. This material is the result of tax-supported research and as such is not copyrightable. It may be freely reprinted with the customary crediting of the source. UT Publication Authorization Number R ii

4 Preface Preface This 2009 volume of An Economic Report to the Governor of the State of Tennessee is the thirty-third in a series of annual reports compiled in response to requests by state government officials for assistance in achieving greater interdepartmental consistency in planning and budgeting efforts sensitive to the overall economic environment. Both short-term, or business cycle-sensitive forecasts, and longer-term, or trend forecasts, are provided in this report. The quarterly state forecast through the first quarter of 2011 and annual forecast through 2018 represent the collective judgment of the staff of the University of Tennessee s Center for Business and Economic Research in conjunction with the Quarterly and Annual Tennessee Econometric Models. The national forecasts were prepared by IHS Global Insight, Inc. Tennessee forecasts, current as of January 2009, are based on an array of assumptions, particularly at the national level, which are described in Chapter One. Chapter Two details evaluations for major sectors of the Tennessee economy, with an agriculture section provided by the University of Tennessee Agricultural Policy Analysis Center. Chapter Three presents the long-run outlook and forecast for the state. Chapter Four present long-range population projections for the state and its 95 counties. The primary purpose of this annual volume published, distributed, and financed through the Tennessee Department of Finance and Administration, Tennessee Department of Economic and Community Development, the Tennessee Department of Revenue, the Tennessee Department of Labor and Workforce Development, and the Appalachian Regional Commission is to provide wide public dissemination of the most-current possible economic analysis to planners and decision-makers in the public and private sectors. Matthew N. Murray Associate Director and Project Director Center for Business and Economic Research iii

5 Contents Contents The U.S. Economy Introduction The U.S. Economy: Year in Review...3 Components of GDP...3 Inflation and Prices...6 The Labor Market The U.S. Forecast...12 Consumption and the Labor Market...12 Investment and Interest Rates...12 Government Spending...14 International Trade...14 Prices and Inflation Alternative Scenarios Forecast Summary and Conclusions...16 The Tennessee Economy: Short-Term Outlook Introduction The Current Economic Environment...18 Housing...18 The Labor Market...18 Personal Income, Earnings and Sales...22 State Revenues Short-term Outlook...28 State Labor Markets...28 Personal Income, Earnings and Sales Situation and Outlook for Tennessee Agriculture...31 Overview of Agriculture in Tennessee...31 Tennessee Agricultural Sector Outlook...33 Ag Sector Issues and Opportunities...35 Trade Negotiations and Agriculture...36 Farm Policy Issues...37 The Tennessee Economy: Long-Term Outlook Introduction Economic Growth in Tennessee: The Labor Force and Unemployment Rate...40 Employment...43 Personal Income and Gross Domestic Product th Century Recessions and Effects on Tennessee...48 What is a Recession?...48 The Great Depression...49 Post-War Ripples...50 Stagflation and Oil Shocks...51 The Not-So-New Economy...52 Tennessee in Recession...52 Federal Reserve System Policy Tools...53 What s Different about This Recession?...54 Oil Prices and Recession...55 References...57 iv

6 Contents Contents, continued Tennessee Population Trends: Introduction Census...60 History...60 How the Census is Used Population Projections...62 Introduction...62 Population Projections Methodology...62 Population Trends in Tennessee...63 Appendix A: Forecast Data...1 Appendix B: Historical Data...41 v

7 Contents Figures and Tables The U.S. Economy...1 Figure 1.1. Inflation-Adjusted GDP Growth...3 Figure 1.2. Home Prices and Housing Starts...4 Figure 1.3. Mortgage Rates and New Home Sales...5 Figure 1.4. International Trade...8 Figure 1.5. Inflation...8 Figure 1.6. Average Gasoline and Oil Prices...9 Figure 1.7. Unemployment Rates...10 Figure 1.8. Employment Growth...10 Figure 1.9: Worker Productivity Figure 1.10: Annual Growth in Primary Components of GDP...13 The Tennessee Economy: Short-Term Outlook...17 Table 2.1. Residential Building Permits, November 2008 Relative to November Figure 2.1. Number of Unemployed People, Tennessee, to (seasonally adjusted)...19 Figure 2.2. Change in Unemployment Rate, November 2007 to November Figure 2.3. Unemployment Rate, Southeastern States and U.S., Annual 2007 and November Figure 2.4. Nonfarm Job Growth, to Figure 2.5. Nonfarm Job Growth, Southeastern States and U.S., Annual 2006 to 2007 and Nov to Nov Figure 2.6. Quarterly Sales Tax Revenue July September, 2007 to 2008, Percent Change...25 Figure 2.7. Sales and Use Tax Collections, Tennessee, January 2001 to November Figure 2.8. Job Growth by Sector, Tennessee, 2009 and Table 2.2: Selected U.S. and Tennessee Economic Indicators, Seasonally Adjusted...30 Figure 2.9. Leading Tennessee Commodities for Cash Receipts, The Tennessee Economy: Long-Term Outlook...39 Figure 3.1. Labor Force Growth...41 Figure 3.2. Annual Unemployment Rate, 1998 to Figure 3.3. Average County Unemployment Rate, Figure 3.4. Distribution of Nonfarm Jobs, Tennessee...44 Figure 3.5. Annual Nonfarm Job Growth, 1998 to Figure 3.6. Average County Job Growth, Figure 3.7. Per Capita Personal Income, Tennessee as a share of the U.S., 1998 to Figure 3.8. Average Per Capita Income, Table 3.1. Recessions 1929 to Present...48 Figure 3.9. U.S. Inflation-Adjusted Annual Percent Change in GDP and Recessions...50 vi

8 Contents Figures and Tables, continued Figure U.S. Unemployment...51 Figure Tennessee Tax Collections, Year-over-year growth, Real Price of U.S. Crude Oil Imports and Recessions, Figure Annual Average Unemployment Rate (seasonally adjusted), 1976 to Tennessee Population Trends: Figure 4.1. Total Population in Tennessee, with Percent of Population over Table 4.1. Age-related population characteristics from 2000 to Table 4.2. Population projections for 2010 and 2020, with Census 2000 data Table 4.3. Counties ranked, from highest to lowest, by net population change...69 Table 4.4. Counties ranked, from highest to lowest, by percent population change...69 Figure 4.2. Ten Counties with Highest Percent of Population Over 65 in Figure 4.3. Counties with Highest and Lowest Percent Change in Over-65 Population, 2000 to Figure 4.5. Counties with Highest and Lowest Percent Change in Under-18 Population, 2000 to Appendix A: Forecast Data...1 Appendix B: Historical Data...41 vii

9 Executive Summary Executive Summary The U.S. Economy The U.S. economy has been in a recession since December of 2007 as the housing bubble deflates, access to credit has been extremely limited, and uncertainty and pessimism has made consumers and producers cut back. Inflation-adjusted gross domestic product (GDP), the most popular measure of economic activity, grew only 1.2 percent in 2008, the fourth consecutive year of slowing growth. Most sectors of the economy experienced either sluggish or negative growth. Consumption, which accounts for roughly two-thirds of GDP, grew only 0.3 percent, reflecting a decline of 4.3 percent in the consumption of durable goods such as appliances and automobiles. Residential fixed investment (housing) fell 21 percent in 2008, even larger than the 18 percent drop in Business investment grew at only 1.9 percent, buoyed by continued strong growth in structures. A weak dollar contributed to decreased imports (3.1 percent) and increased exports (6.4 percent). While inflation was a concern during the first half of the year, decreased demand has begun to push prices down. By December of 2008, the Consumer Price Index (CPI) was 0.1 percent lower than it was a year earlier. Falling prices and weak demand have caused employers to cut back, laying off workers and furloughing many more. Unemployment averaged 5.8 percent in Economic conditions deteriorated significantly as the year came to a close. In December, all 50 states saw their unemployment rates increase, the first time this happened since records have been kept. Economic activity is projected to decrease over the course of 2009 as we endure one of the most severe recessions since the Great Depression. We expect inflation-adjusted GDP to decrease by 2.5 percent in All sectors are expected to shrink, highlighted by sharp reductions in investment by both households and businesses due to a substantial contraction in credit availability. Residential investment will shrink by another 21 percent while businesses reduce investment by 15 percent. Consumption spending will decrease by 0.9 percent as stagnant incomes, a weak labor market, and limited access to credit cause consumers to save. Weak economic conditions across the globe will reduce the flow of international trade as well. U.S. imports and exports are expected to decrease by 9.6 and 7.0 percent, respectively. Since interest rates are already extremely low, the federal government will look towards government spending to help boost the economy. As this report goes to print, a massive fiscal stimulus bill is being debated in Congress. Some form of increased spending will almost surely be passed. As such, we expect a large increase in government spending in 2009, with federal expenditures rising by 3.2 percent. Growth should resume in the middle of the year or by 2010 as credit markets begin to thaw and confidence in financial markets is renewed. Unfortunately, there are no signs of a turnaround at this early point of The Tennessee Economy Current Economic Conditions Statewide economic conditions deteriorated markedly over the course of The unemployment rate rose, income growth slowed and jobs contracted for the year. The unemployment rate peaked at 7.9 percent in December and averaged 6.4 percent for the year; the unemployment rate stood at 4.7 percent in Nonfarm jobs fell 0.6 percent in 2008 compared to growth of 0.5 percent viii

10 Executive Summary in the previous year. And nominal personal income saw growth of only 3.7 percent, about 70 percent of growth in the previous year. Based on the trajectory of the national economy, expect conditions to deteriorate further through at least the first half of the year. Tennessee s unemployment rate rested at a recent low of 4.5 percent in the first quarter of 2007, but has drifted up each quarter since then. The number of unemployed people has surged in recent quarters, including a 79.9 percent increase in the second quarter of last year. Labor market weakness has contributed to a shrinking statewide labor force in the third quarter of last year and a falling labor force participation rate as the year progressed. Not surprisingly, the rising unemployment rate has been accompanied by significant job losses. After growing in each quarter of 2007, seasonally-adjusted nonfarm jobs began contracting in the first quarter of Most broad sectors of the economy are now in decline, aside from education and health services and government. Setbacks in manufacturing have accounted for most of the overall nonfarm job losses. Seasonally-adjusted personal income growth was in the red in the third and fourth quarters of 2008, the first time income has contracted in recent history (i.e., dating back to the second quarter of 2005). Wage and salary income is weakening as jobs contract, with overall wage and salary income falling in the second and fourth quarters of last year. As with overall personal income, there is no period in recent history with declines in wage and salary income. As income growth has weakened, so to have taxable sales. After growing 4.1 percent in 2007, taxable sales declined 1.6 percent in The state s sales tax is performing worse than the national average, as is the case with the sales tax in many other states in the southeast. Short-Term Economic Outlook Tennessee s fate depends on the path taken by the global and national economies in the months ahead. Unfortunately, there is no sign of a bottom to the current cycle. To the contrary, by all accounts economic conditions are deteriorating at a more rapid pace. One good indicator is payroll employment for the national economy: 1.9 million of the 2.6 million jobs lost nationwide in 2008 were in the final four months of the year. A turnaround is expected in the third quarter as monetary policy, a second fiscal stimulus package and improved housing market conditions lift the economy from bottom. But there are concerns that the economy s rebound will be delayed until the end of the year or early Stronger statewide growth than that predicted here is possible, though highly unlikely given current conditions. Nonfarm jobs in Tennessee are expected to fall at least 2.2 percent this year and be down 0.3 percent in The state s manufacturing sector will suffer a 6.0 percent setback in 2009 and further losses of 3.8 percent next year. The unemployment rate will rise steadily over the year and reach a peak of 9.8 percent in the first quarter of next year. The annualized unemployment rate will be 8.9 percent this year and 9.6 percent in Nominal personal income will see growth of only 0.7 percent in 2009, improving to 2.8 percent growth next year. Because deflation is expected for this year, inflation-adjusted income will actually grow at a faster rate than nominal income. There is no modern precedent for this expected phenomenon. Nominal taxable sales will continue their slide, yielding a decline of 4.5 percent in 2009 and rebounding with 2.3 percent growth in On a fiscal year basis, taxable sales should fall 5.1 percent this fiscal year and shrink 0.1 percent in the 2009/10 fiscal year. Long-Term Outlook All eyes today are on the recession, looking for a bottom to the current downturn and a return to growth. Given the depth and breadth of the recession, this is no surprise. Shortrun business cycles can have a significant impact on long-run economic growth. A good example is the early 1980s when the economy experienced back-to-back recessions. It took several years to eliminate the high levels of unemployment that were created as a result of these downturns. Long-term growth also ix

11 Executive Summary depends fundamentally on growth in the labor force, the educational attainment levels of the workforce, private investments that businesses put into the production process and public infrastructure and services that help grease the skids for the economy. Education is especially important to economic wellbeing: Tennessee counties with welleducated adult populations enjoy lower rates of unemployment, higher rates of job creation and higher levels of per capita income than their more poorly-educated counterparts. Tennessee s growth dating back to 1998 has lagged the nation s pace of growth, both in terms of jobs and personal income. Tennessee s per capita personal income has also fallen relative to the national average. These trends are expected to continue into The state will see jobs grow 0.7 percent while the nation will see 0.8 percent job growth between 2008 and 2018 (compound annual growth rates). Tennessee s personal income growth will also trail the nation s rate of income growth in the years ahead. Unemployment rates for the state and the nation will stay at stubbornly high levels for several years to come, an unfortunate legacy of the current recession. A long view of U.S. economic history confirms that the Great Depression is in some ways comparable to the current U.S. recession. While we are not likely to see unemployment reach a quarter of the population, such as in the Great Depression, the loss of wealth seen in the credit crisis may be nearly as severe. The Federal Reserve has played a prominent role in each of the twentieth century recessions, but not always as a lifeline for markets. In fact, many recessions have been caused or worsened by restrictive monetary policy implemented by the Federal Reserve. Increases in government spending have had inconsistent outcomes in periods of recession. The most effective anti-contraction spending has been financed with a federal budget deficit. In general, additional expenditures by the federal government financed through increased taxation have had a negative effect on the economy. Perhaps the most important lesson of the recessions of the twentieth and twenty-first centuries is that each has resulted from a unique set of circumstances and has been resolved through a unique set of actions or inaction. However, the business cycle has proved to be an immovable feature of capitalism. As we move forward attempting to resolve the current credit crisis and accompanying recession, unique tools will once again be required to engineer an economic turnaround. Population The 2010 Census will determine over $3 trillion in federal government outlays over the next 10 years. Because official Census counts will be used by many federal agencies for distributing funds to state and other governments through the state, there are obvious and important financial consequences to ensuring all state residents are correctly tallied in The number and geographic distribution of the population can also have important political implications, since Census counts form the basis for allocating congressional seats. Clearly, the 2010 Census will be critical in establishing the number of people residing in the state of Tennessee. While the Census provides a full count of the population every 10 years, it is also important to have estimates of what future population counts will be. In the coming years there are many demographic changes that will be facing Tennessee and the nation as a whole, including the aging of the Baby Boom generation, increases in life expectancy, changes in the fertility rate, and migration. Using population projections, we forecast the total population, by age and sex, for all counties in the state of Tennessee from 2000 to The statewide population total for Tennessee in 2005 was just under 6 million people, making it the 16th most populous state in x

12 Executive Summary the U.S. including the District of Columbia. In 2010, the population is projected to be 6.2 million, rising to 6.8 million in While Tennessee is growing, the rate at which it has grown has changed. From 1990 to 2000 the annual rate of growth was 1.7 percent slightly higher than the national average of 1.3 percent over the same time period. From 2000 to 2020, both the state and the nation s growth will slow to an annual rate of 1 percent. Compared to the 1990s when every county saw at least modest population gains, just over 20 percent of counties will see population declines between 2000 and The declines will mostly occur in the population under age 65; while only 2 counties in the state will see decreases in the over-65 population between 2000 and 2020, nearly 40 percent of counties will see declines in the under-18 population, and nearly 30 percent will see losses in the age group. The changing age structure of the population will present unique opportunities and challenges for Tennessee in the next decade. xi

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14 The U.S. Economy Chapter 1 The U.S. Economy In this chapter 1.1. Introduction 1.2. The U.S. Economy: Year in Review Components of GDP Inflation and Prices The Labor Market 1.3. The U.S. Forecast Consumption and the Labor Market Investment and Interest Rates Government Spending International Trade Prices and Inflation 1.4 Alternative Scenarios 1.5 Forecast Summary and Conclusions 1.1. Introduction The slumping U.S. economy continued its descent into 2009 as uncertainty in financial markets sapped the confidence of consumers, producers, and investors alike. In fact, the National Bureau of Economic Research, the organization officially responsible for determining the beginning and ending of recessions, confirmed what many suspected that the U.S. economy was shrinking. More specifically, they determined that the economy had entered a recession in December of 2007 and has been in one ever since. While there was certainly no shortage of dreary economic headlines throughout last year, the most notable were the collapse of several financial institutions, including investment banking giants Lehman Brothers and Bear Stearns and insurance conglomerate American International Group (AIG). At the heart of these failures was the continued turmoil in housing and real-estate related asset markets. Such events have shaken confidence in financial markets and drastically limited the availability of credit, making producers weary or unable to expand or, in many cases, even continue production. Consumers have also been affected by tighter lending, unable to secure mortgages and lines of credit for other big-ticket items such as automobiles and home appliances. Policymakers have responded in a variety of ways. The Federal Reserve has dropped the federal funds rate to almost zero, attempting to spur investment and borrowing-fueled consumption. In order to stem the harmful spillover of failing banks into other sectors of 1

15 Chapter 1 The U.S. Economy 1.1. Introduction, continued the economy, Congress has given the Treasury Department authority to purchase up to $700 billion of assets from failing financial institutions through the Troubled Asset Relief Program (TARP). So far, half of this money has been spent, while the Senate approved to release the second half on January 15, In order to encourage continued faith in the banking system, the Federal Deposit Insurance Corporation (FDIC) has increased its guarantee on individual deposit accounts from $100,000 to $250,000. While there has been no sign of recovery in the near-term, these policies may have prevented further economic collapse. As this report goes to print, policymakers are also discussing the possibility of a massive fiscal stimulus bill, the cost of which may approach $1 trillion. While specific details of a final plan are unavailable at this point, it is likely to include tax cuts, programs aimed at homeowners at risk for foreclosure, investments in infrastructure, and transfers to state and local governments. This chapter provides an overview of the nation s current economic situation as well as a short-term forecast of things to come. 1 As this goes to print, inflation-adjusted gross domestic product (GDP) is reported to have declined at an annual rate of only 3.8 percent in the fourth quarter of 2008, better than has been expected. 2 Unfortunately, the downward trend is expected to continue well into 2009, with minimal growth occurring in the second half of the year. Overall, the economy is expected to shrink by about 2.5 percent in The harmful effects of deflation (falling prices) combined with continued weakness in housing markets will drive down consumption and investment demand, leading to a 2.6 percent reduction in payroll employment and an unemployment rate of 8.5 percent. Strong growth should resume by the second half of 2010 as the housing market begins to rebound from its historic decline and credit markets unfreeze, once again giving producers and consumers sorely-needed access to funds. 1 CBER draws its U.S. forecast from IHS Global Insight, Inc. 2 Unless otherwise noted, all growth rates in this chapter are seasonally adjusted annual rates (SAARs). 2

16 The U.S. Economy Chapter The U.S. Economy: Year in Review Gross Domestic Product (GDP) is the most widely-cited measure of economic activity. It measures the total production or value of goods and services produced and consumed in the country in a given period of time. For the first time since 2001, inflation-adjusted GDP fell at the end of 2007, ending a string of 24 consecutive quarters of growth (see Figure 1.1). While recovering from a recession in 2001, the economy grew at around 3 percent per year until mid Growth was sluggish for most of the subsequent twelve months. Output growth picked up briefly in the second and third quarters of 2007, but the economy has slipped considerably ever since. The third quarter of 2008 exhibited annualized inflation-adjusted GDP growth of -0.5 percent. The fourth quarter showed only a 3.8 percent setback, better than the 5.6 percent loss that was expected. However, all indications are that fourth quarter growth will be significantly less. Consumer sentiment is at its lowest point since 1980 and data on retail sales for November and December show a sharp decline, dashing any hopes for a rebound driven by holiday shopping. In fact, fourth quarter GDP is expected to have decreased by an annualized 5.6 percent, the largest quarterly drop in almost thirty years. Overall, GDP is expected to have increased by only 1.2 percent in 2008, the smallest increase since Much of this gain can be attributed to fiscal policy actions such as the distribution of $375 billion in TARP funds and the tax rebates of last spring. Components of GDP By definition, GDP is the sum of spending by consumers on durable goods, non-durable goods, and services, investment spending (residential and non-residential construction, equipment, inventories, etc.), purchases by all levels of government, and net trade in international markets (exports minus imports). While we look to total GDP to draw broad conclusions on the overall status of the economy, it is extremely useful to look at these individual components to identify underlying trends and determine which sectors are contributing to growth, or decline, in the economy. The largest component of GDP is consumption spending, which typically comprises about two-thirds of total GDP. Figure 1.1. Inflation-Adjusted GDP Growth growth rate (%) Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 Note: Seasonally-adjusted annual rate Source: Bureau of Economic Analysis 3

17 Chapter 1 The U.S. Economy 1.2. The U.S. Economy: Year in Review, continued After growing roughly 3 percent per year from 2005 to 2007, inflation-adjusted consumption increased by only 0.3 percent in This is the slowest growth since 1991, another recession year. Much of the slowdown occurred in the second half of the year, with declines of 3.8 and 2.6 percent in the third and fourth quarters, respectively. Consumption spending can be broken down further into three main categories: durables, non-durables, and services. Durable goods are things like appliances and automobiles while examples of non-durable goods are clothing and food. Although growth in all three categories was either flat or negative, it was the significant contraction in sales of durable goods that was most noteworthy, falling in every quarter of This is likely due to shaky consumer confidence and uncertainty regarding future economic conditions. Since durable goods tend to be large purchases, many households will avoid making these types of purchases if they are concerned about job security or future income in a shaky economy. This is particularly evident for automobile sales, which fell 18 percent in 2008, the largest drop since All in all, spending on durable goods fell by 4.3 percent for the year. Sales of nondurable goods, which are typically more stable since many non-durable goods are considered necessities, even fell slightly (0.3 percent). Spending on services (haircuts, oil changes, etc.) grew by only 1.5 percent. Quite often, the last few months of the year provide a boost to end-of-year consumption figures as holiday shopping is in full swing. This was not the case in 2008, with total retail sales falling 8.2 and 9.8 percent in November and December, respectively, compared to the same months in These are the two largest year-over-year drops since those data began being collected in Like consumption, investment can be separated into several categories, many of which experienced negative growth in Residential fixed investment (housing) decreased by 21 percent over the course Figure 1.2. Home Prices and Housing Starts growth rate (%) Home Prices Single-Family Housing Starts Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 Note: Series are seasonally-adjusted annual rates Source: Census Bureau and Fannie Mae 4

18 The U.S. Economy Chapter The U.S. Economy: Year in Review, continued of the year, with every quarter displaying larger drops than the one before. Residential investment fell at an annual rate of almost 27 percent in the fourth quarter, the twelfth consecutive quarter of negative growth. Since this includes new housing construction, it is of no surprise that new housing starts have experienced an equally drastic decline, as shown in Figure 1.2. Housing starts are now at levels around one-third of their peak in the first quarter of As discussed in Chapter 2, the number of new building permits issued is down sharply in Tennessee as well. Home values have also continued to plummet, falling at an annualized rate of almost 12 percent in the third quarter of 2008 (see Figure 1.2), the largest such drop in history. Continuing falls in housing prices and labor market uncertainty have caused potential first-time homebuyers to delay buying with the hope that prices will fall even further, despite historically low mortgage rates, which have fallen for much of the past year and a half. Further exacerbating the housing market situation is limited access to credit. Even those with relatively strong credit histories are finding it difficult to secure financing. Accordingly, the number of home sales has dropped consistently since the middle of Figure 1.3 shows the average rates on a 30-year fixed-rate mortgage as well as the number of home sales. Although non-residential, or business, investment ended the year with positive growth of 1.8 percent, the trend is not encouraging. Business investment fell at an annual rate of over 18 percent in the fourth quarter of 2008, the largest such drop in over two decades. Much of this decrease is due to producers cutting back on purchases of equipment and software, which fell at an annual rate of 25.5 percent in the fourth quarter. The lone bright spot is the continued investment in business structures, which grew 11 percent in However, even this category of investment fell at an annual rate of 5.2 percent in the fourth quarter after three years of sustained strong growth. This does Figure 1.3. Mortgage Rates and New Home Sales Year Fixed Mortgage Rate New Single-Family Home Sales (SAAR) 1,600 1, ,200 mortgage rate (%) , thousands of homes Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul Source: Census Bureau and Fannie Mae Source: Census Bureau and Fannie Mae 5

19 Chapter 1 The U.S. Economy 1.2. The U.S. Economy: Year in Review, continued not bode well for the construction industry now that investment in both residential and business structures is falling. Government spending grew by an annualized 5.7 percent at the federal level and 1.2 percent at the state and local level in This represents a sharp increase in federal spending from 2007 (1.6 percent) and a reduction in state and local spending growth (2.3 percent). The growth at the federal level is likely due to increased borrowing to fund several new spending programs designed to combat the struggling economy as well as further increases in defense spending. Reductions in personal and corporate income and sales tax receipts have crippled the budgets of many sates and localities. The trend of improving trade balances continued in 2008, with sales of U.S. goods to foreign markets growing faster than imports for the fourth consecutive year. More specifically, exports grew at 6.4 percent while imports actually fell for the first time since 2001, by 3.1 percent. Since spending by domestic consumers on imported goods is counted in consumption, it is subtracted from export sales in order to avoid double counting and accurately determine how international trade has contributed to economic activity. Historically, U.S. imports have exceeded exports, subtracting from GDP and hindering economic growth. Fortunately, strong export growth for the past several years has led to declining trade deficits, as shown in Figure 1.4. However, weak global demand along with an appreciating dollar has recently led to a decline in U.S. export activity, with exports falling at an annual rate of 21 percent in the fourth quarter of Exports had been a major source of domestic economic growth, with growth rates higher than that of overall GDP for much of the past five years. Inflation and Prices Inflation is commonly measured as the change in the Consumer Price Index (CPI) in one period compared to another. The CPI is designed to measure the cost of a typical market basket of goods and services that a typical household purchases. Figure 1.5 shows the monthly change in the CPI from the same month in the prior year. Prices began to rise quickly in the second half of 2007, with inflation rates reaching 5.5 percent in July, Much of this was due to skyrocketing energy, food, and commodity prices. This caused a great deal of concern for policymakers since maintaining low levels of inflation has been a primary goal of the Federal Reserve, which can influence inflation rates by controlling the nation s money supply and determining key interest rates. As consumption and investment demand continued their dramatic retreat in the second half of 2008, prices have begun to fall. Annual inflation actually decreased in December, with the CPI 0.1 percent less than it was a year earlier, the first year-over-year drop since the 1950s. Prices have fallen every month since August, with the largest drop occurring from October to November. While we typically welcome low rates of price growth, we want to avoid prolonged periods of falling prices, or deflation. If producers and consumers begin to expect prices to fall, then consumers will delay spending as long as possible in an attempt to buy at a later date when prices are lower. Similarly, producers will not make investments in capital equipment if they expect lower equipment prices in the future and also expect to receive a lower price for their products. Low demand for goods and decreased production can lead to rising unemployment and falling incomes as producers strive to cut costs and reduce inventory. This can become a vicious cycle of falling prices and incomes and rising unemployment. A recent example is Japan, which entered a deflationary period in the early 1990s, prompting a decade of stagnant growth. Often it is useful to exclude some items from the CPI in order to determine which goods are driving the movement in overall prices. Figure continued on page 9 6

20 The U.S. Economy Chapter The U.S. Economy: Year in Review, continued The Credit Crunch Perhaps the most significant economic event of 2008 was the so-called credit crunch, when financial institutions, saddled with declining asset values, began to hoard cash rather than issue new loans in order to stay solvent. There is no single cause or simple explanation for how this came about. In some sense, the current state of credit markets and the financial industry in general is the result of a perfect storm of several trends, discussed in the following paragraphs. Throughout the late 1990s and early 2000s, home prices rose at an unprecedented pace. As housing became less affordable, home buyers stretched their budgets and took out exotic mortgages in order purchase expensive homes. Since home value were rising, mortgage companies relaxed lending standards, issuing loans to borrowers with substandard credit ratings and requiring small down payments. After all, if the borrower defaulted the bank could repossess the home, which would be worth more than the balance due on the mortgage thanks to appreciation. The past decade has also ushered in the prevalence of mortgage brokers. In the past, financial institutions that issued mortgages would typically own and service the loans throughout their lifetimes. Thus, they had every incentive to ensure the credit worthiness of those to whom they were lending money. Conversely, mortgage brokers issue loans and sell them to banks, greatly reducing the future repercussions of making a bad loan. Companies that owned or originated mortgages often packaged them into bundles called mortgage-backed securities, selling them as investments to institutions such as pension funds, insurance companies, hedge funds, and banks. Since home values were rising, parties at each of level of this process did not closely examine these mortgages and accurately assess their risk. Companies such as Wachovia, Bear Stearns, Countrywide, and even Bank of America had billions of dollars worth of mortgages and mortgage-backed securities listed as assets on their balance sheets. When home prices began to fall, the system unraveled. Subprime borrowers, homeowners who purchased homes they could not afford, and those with adjustable-rate mortgages facing interest rate hikes began to default on their payments at an alarming rate. These defaults decreased the value of mortgage-backed securities, which depend on homeowners mortgage payments to generate income for the investor. Losses mounted as the value of these securities plummeted. In many cases, the quality of mortgages in the asset was unknown. This uncertainty combined with the high probability of increasing defaults due to further declines in home values essentially eliminated the market for mortgage-backed securities, leaving many firms stuck with worthless assets. As the value of mortgage-backed securities fell, so did the strength of firms balance sheets. These firms were saddled with bad assets that had stopped generating income, unable to secure funding due to lack of sufficient collateral. Since ownership of mortgage-backed securities was widespread, bankto-bank lending activity decreased. Lenders could not be sure of repayment since the assets of borrowers were shrinking by the day. By the fall of 2008, bank-to-bank lending was almost nonexistent. The credit freeze has spilled over into the broader economy as banks struggled with deteriorating balance sheets. For reasons outlined above, they could not borrow from other banks in order to make loans to firms or consumers. Instead of using the cash they had on hand to make loans, they held it in order to improve their balance sheets and maintain solvency. As a result, firms have been unable to secure credit for investment in capital equipment or to cover payroll, leading them to reduce production and lay off workers instead. Consumers, even those with good credit, have found it difficult to obtain financing for such things as going to college and purchasing automobiles, decreasing demand for many goods and services. This lack of available credit has contributed to the spiral of decreasing demand, falling prices, and shrinking production that we have witnessed over the past several quarters. 7

21 Chapter 1 The U.S. Economy 1.2. The U.S. Economy: Year in Review, continued Figure 1.4. International Trade Figure 1.4. International Trade T rade deficit (left axis) E xports (right axis) Imports (right axis) billions of dollars growth rate (% ) Source: Bureau of Economic Analysis. Figure 1.5. Inflation Figure 1.5. Inflation CPI CPI excluding food and energy year-over-year change (%) Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Source: Bureau of Labor Statistics Source: Bureau of Labor Statistics 8

22 The U.S. Economy Chapter The U.S. Economy: Year in Review, continued 1.5 also displays the change in price of a basket of goods that excludes food and energy, the prices of which can be particularly volatile. This is often referred to as core inflation. Once food and energy prices are removed, inflation appears to be much more stable and was in a more desirable range of 2 to 2.5 percent for 2008, dropping slightly as the year came to a close. Since overall inflation is much lower than core inflation, we might expect the difference to be driven by energy and/or food prices. Figure 1.6 shows historical oil and gasoline prices. The price of oil has dropped from an average of about $134 per barrel in June of 2008 to about $40 per barrel in December as economic slowdown across the globe has tempered onceskyrocketing energy demand. Retail gasoline prices have followed in step, falling from an average of over $4.00 per gallon during the summer to under $1.70 at the end of the year. The Labor Market Underscoring the contraction of the U.S. economy has been a tumultuous labor market. Figure 1.7 shows the civilian unemployment rate, which measures the share of the national labor force that is out of work but actively seeking employment. Unemployment has risen steadily throughout the past year and a half, up from 4.4 percent in March of 2007 to currently over 7 percent. Even worse, the upward trend has become more severe over the past few months, with a rise from 6.2 percent in September to 7.2 in December. This is highest unemployment rate since the early-1990s. Unfortunately, unemployment rates tend to underestimate weakness in the labor market because many people who struggle to find jobs get discouraged and simply quit looking, dropping out of the labor force entirely. These people are not counted when calculating the unemployment rate. Further, workers whose hours are cut back are still counted as being employed, despite the reduction. Anecdotal evidence suggests a recent wave of furloughs, the scope of which seems unprecedented, contributing to labor market weakness. Figure 1.7 also shows the unemployment rates of adult males and females aged 20 years and older. Historically, these groups Figure 1.6. Average Gasoline and Oil Prices $4.50 $4.00 Average U.S. Retail Gasoline, All Grades West Texas Intermediate Oil $ $ $3.50 $ dollars per gallon (gasoline) $3.00 $2.50 $2.00 $1.50 $1.00 $ $80.00 $60.00 $40.00 dollars per barrel (oil) $0.50 $20.00 $0.00 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 $0.00 Source: Energy Information Administration and the Federal Reserve Bank of St. Louis Source: Energy Information Administration and the Federal Reserve Bank of St. Louis 9

23 Chapter 1 The U.S. Economy 1.2. The U.S. Economy: Year in Review, continued Figure 1.7. Unemployment Rates Figure 1.7. Unemployment Rates Overall Adult Males Adult Females unemployment (%) Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 Note: Series is seasonally-adjusted Source: Bureau of Labor Statistics Note: Series is seasonally-adjusted Source: Bureau of Labor Statistics 4.0 Figure 1.8. Employment Growth Figure 1.8. Employment Growth growth rate (%) Total Non-Farm Service-Producing Goods-Producing Q1 2001Q1 2002Q1 2003Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 Note: Series are seasonally-adjust annual rates Source: Bureau of Labor Statistics Note: Series are seasonally-adjust annual rates Source: Bureau of Labor Statistics 10

24 The U.S. Economy Chapter The U.S. Economy: Year in Review, continued have had unemployment rates roughly 0.7 and 0.5 percentage points lower than overall unemployment, respectively. However, unemployment among adult males has risen much faster than that among women and the overall population, reaching 7.2 percent in December of This is likely due to the fact that sectors of the economy that are struggling more heavily, such as construction and the manufacturing of automobiles and heavy machinery employ a disproportional share of males. It is no surprise that a rising unemployment rate corresponds to falling employment. Annualized employment growth, shown in Figure 1.8, has fallen since late However, non-farm payroll growth did not turn negative until 2008, and since that time the labor market has continued to contract. In fact, the economy has now shed jobs for twelve consecutive months. Total non-farm employment declined at an annual rate of 3.7 percent in the fourth quarter of the year, the largest quarterly drop since Overall, 2.6 million jobs were lost in Goods-producing industries have shed the largest fraction of jobs, with employment decreasing at an annual rate of 9.2 percent in the fourth quarter of 2008 (see Figure 1.8). Employment in these industries has decreased for 10 consecutive quarters. Although manufacturing employment has been in steady decline since the late 1970s, an even greater share of recent job losses have come from that sector. Over the past decade, manufacturing jobs have decreased by over 4 million, which represents a 23 percent decline. There are 430,000 fewer manufacturing jobs at the end of 2008 than there were at the beginning of the year, which followed a drop of 275,000 jobs in Employment in service-based industries has decreased slightly less than in the overall economy, slipping into negative growth only in the second half of the year. Figure 1.9 shows the change in average worker productivity over the past six years. Although employment has decreased sharply, worker productivity was relatively strong in 2008, growing at 2.6 percent, the highest level since Solid productivity gains have helped to offset the steady fall in manufacturing and overall employment. However, these gains have slowed considerably, with the third and fourth quarters exhibiting growth of only 1.3 and 0.4 percent, respectively. 5.0 Figure 1.9: Worker Productivity 4.0 growth in output per hour (%) Q1 2004Q1 2005Q1 2006Q1 2007Q1 2008Q1 Note: Seasonally-adjusted annual rate Source: Bureau of Labor Statistics 11

25 Chapter 1 The U.S. Economy 1.3. The U.S. Forecast The economy will continue its contraction at least through the first half of 2009, eventually generating slow, but positive, growth around mid-year. The major factors contributing to the turnaround will be thawing credit markets resulting from low interest rates and the continued injection of federal funds into the financial sector, stabilization in the housing market as low prices finally attract pent-up demand, and the passage of a massive federal stimulus bill. However, late-year gains will not be enough to offset significant declines in the first and second quarters. Inflationadjusted GDP will decrease by 2.5 percent in 2009, leaving year-end growth in negative territory for the first time since This drop would be the largest since 1948, when inflation-adjusted GDP began being calculated. All broad sectors of the economy are expected to decline in the coming year, with the exception of government spending, as shown in Figure Contributing to this decline will be falling consumer prices, further declines in housing markets, and extremely weak labor markets. Consumption and the Labor Market Labor market conditions are expected to deteriorate further in 2009, with employment falling by 2.6 percent, the largest drop in over a decade. This represents the elimination of about 3.5 million jobs, most of which are likely to be lost in manufacturing and other goodsproducing industries, and will bring total employment back to 2005 levels. Most of this decline is expected occur in the early part of the year, with annualized declines in the first and second quarters of 4.1 and 2.8 percent, respectively. Declining payrolls will push the unemployment rate to almost 9 percent by the end of 2009, the highest since Even those with job security will see their incomes stagnate, although positive gains in productivity will keep personal income growth from turning negative. Productivity is expected to increase by only 1.1 percent in 2009, less than half of what it was in Significant job losses combined with modest productivity gains will contribute to stagnant growth in personal income, which is expected to grow by less than 1 percent the lowest since those data have been collected beginning in These factors, along with further declines in housing wealth, will take their toll on consumption spending as households cut back, particularly on bit-ticket purchases. As a result, spending on durable goods is projected to decline by 6 percent, outpacing last year s decline of 4.3 percent. However, the entire decline is expected to be concentrated in the first quarter, with strong growth in the remainder of the year. Non-durable consumption will fall by less than 2 percent. Fortunately, consumption of services is expected to finish the year in the black, posting a small increase of 0.4 percent, with larger gains as the year progresses. Overall, consumption spending is expected to fall by 0.9 percent in 2009, the first outright annual decline since The silver lining in the bleak consumption outlook for the coming year is that positive income growth, although small, combined with a significant decrease in consumption spending will lead to the highest savings rate in over fifteen years. The national saving rate has been decreasing steadily since the early 1980s. While this may to be just a short-term increase rather than a shift in long-term trend, a higher savings rate provides households with additional cushion against job or income loss and encourages long-term economic growth. Some of this will be out of necessity as a lack of credit availability will force some households to save in order to purchase large items. Investment and Interest Rates Retreating consumer demand combined with the threat of deflation will cause businesses to reduce their investment even further in Following the sharp decline in the fourth quarter of 2008, business investment is projected to decrease by over 15 percent in The largest decreases are anticipated to incur in the transportation equipment and industrial equipment sectors, 12